Bonds Are Back – Part 1 (Why Do We Hate Them?)

Categories : Financial, News
May 3, 2023

ZIRP is an acronym for Zero Interest Rate Policy and, until recently, a major component of American economic policy for several years. Through the Financial Crisis in 2008 and the economic shock of COVID-19 in 2000, the Federal Reserve (FED) exercised the ultimate “easy money” stance of lowering interest rates to essentially zero. (I suppose we should be grateful they didn’t adopt NIRP, the Negative Interest Rate Program, tried by several countries with no apparent success.) ZIRP’s concept is simply to stimulate economic activity in slow economic times.

To what degree ZIRP has been effective is a discussion I will leave to the academics and politicians. However, one result we criticize is that ZIRP divides Americans into two groups: winners and losers. Winners are large corporations and entrepreneurs, who can borrow cheap money for projects that may otherwise not be justified. Losers include investors and lenders, whose ability to make safe money earning interest, is delayed.

Typical investors employ a long-term strategy of owning stocks, bonds, and cash, plus alternatives such as commodities. During good times in the stock market, the highest returns come from stocks. This phenomenon does not go unnoticed by investors, who reflect fondly on their out-sized stock gains over the years. These people look at the bond market, compare their relatively measly returns, and develop a visceral dislike of bonds.

In our financial planning practice, we hear constantly, “I hate bonds.” While common, this attitude sets up portfolios to experience more volatility than most investors find comfortable. One of the fundamental contributions of bonds is reducing that volatility. Bonds are also accretive to long-term returns, furnishing incremental growth and income throughout the bond’s holding period.

Bond issuers are borrowers. In return for loaning them money, issuers promise investors how much, and when, interest will be paid to the bondholder during the holding period. At maturity, the face value of the bond is returned to the bond investor. So, why do so many investors harbor a deep dislike for bonds? Aside from returning less than stocks (in “normal” times), investors are not aware of the long-term impact of bonds in well-diversified portfolios.

We can’t fault any investor whose experience with bonds has been negative. That is largely due to a lack of understanding of bond pricing and variability. Next week we will look at the effects on bond investing from changes in interest rates, including recent FED policy decisions, and discuss strategies to create successful portfolios that include bonds.

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